Tuesday, October 28, 2014

I just read an interesting letter to Jean Tirole, the French economist who got the Nobel Prize for Economics (a prize that, in my view, should be abolished as it promotes economics to a status it does no deserve), written by a colleague of Tirole from Toulouse. I copy the text below and give you the link: https://madmimi.com/p/5b2775?fe=1&pact=25897480694
PS: I just saw there is a link in English, to the blog of the author of the Open Letter, Simon Thorpe: http://simonthorpesideas.blogspot.nl/2014/10/an-open-letter-to-my-colleague-jean.html

Wednesday, October 15, 2014

Avinash Persaud wrote an article (with useful related links at the
bottom) that is worth to be taken seriously by policymakers and
those who would like to influence policies and the policymakers'
minds:

Why We Must Break Up the
Financial Herd

Memories are short. But those in finance are even shorter.
Before the credit crunch began in 2007, policymakers in advanced
economies were flirting with the idea that we should just accept
that financial crises occur every seven years or so and plan
accordingly, as seeking to avert or limit them would suffocate the
financial system. At the time, greater financialization of the
economy, which is when the financial sector accounts for an ever
rising portion of gross domestic product, was seen as an
unambiguous measure of progress. The most financially liberalized
economies—the United States and the United Kingdom—were held up as
exemplars for others to follow, and the rallying cry was "set
finance free."

The credit crunch ended such talk. It reminded the
financial crisis-deniers just how traumatic crises can be and how
slow and hesitant the recoveries are. It also reminded us of the
Faustian pacts that policymakers are forced to make at the height
of a severe financial crisis—for example, trying to revive an
economy after a debt-driven bust through more debt, or employing
the very same individuals who caused or contributed to the crisis
to try to mend things, simply because only they understand the
instruments that need to be disentangled.

During the 2008 US Democratic presidential primaries, one
of Senator Hillary Clinton's mantras was that she was more able
than rival candidates to take that 3:00 a.m. phone call from the
generals about some overseas calamity. During a financial crisis,
the 3:00 a.m. phone call invariably comes not from a general but
from a banker. And invariably he will tell you that unless you
bail out his institution, the whole financial system will
collapse.

It's all very well to sound brave in the abstract and say
the banks should not be bailed out, but when the authorities tried
just that in September 2008 and allowed Lehman Brothers to fail,
financial meltdown followed. In the wake of that collapse, no
major financial institution was able to fund itself without state
support. Calling the bankers' bluff is much harder than it seems
to the wider public. Where possible, it is best to avoid having to
make that call.

In the shadow of the crisis we have returned to a more
nuanced consensus, along lines similar to that which existed in a
previous age: Financial firms can play an important role in
financing growth, but only as part of a financial system that does
not accentuate boom and bust. Let us hope that we do not forget
this lesson too quickly.

In the 10 years prior to the crisis, financial policy was
driven by three main objectives: transparency, standardization (of
value and risk measures), and the removal of restraints on
financial trade-like transaction taxes or capital requirements for
the trading books of banks. Bankers persuaded everyone else that
achieving this holy trinity would deliver an effective financial
system and therefore greater prosperity for all—though it was also
considered foolhardy for regulators to second guess what an
effective financial system should look like.

While there is undoubted merit in transparency and
standardization, and in the removal of trading restrictions, the
manner with which these goals were pursued caused financial
systems to become larger, yet more fragile. It also led to
financial systems with high degrees of trader liquidity, but which
lacked systemic resilience.

False Gods?

Regulators must dare to consider what a resilient
financial system would look like. I would venture that it is one
where a shock in one part of the system can be absorbed by another
part and not spread and amplified across all the others. For this
to happen, we need a financial system in which the different parts
assess, value, hedge, and trade the same assets or activities
differently, not because they have different information,
different forecasts of the world economy, or different risk
appetites, but because they have different objectives, or, more
precisely, different liabilities.

Systemic liquidity does not come from the amount of
turnover or size of markets but from the degree of heterogeneity.
When a shock of some kind leads to a sudden jump in the
precautionary demand for cash, and all banks have to sell assets
to raise cash, the financial system will be better able to absorb
these stresses if life insurance funds or pension funds valued
these same assets on the basis of their ability to meet a future
pension or insurance liability.

On this long-term basis, they may decide that the assets
are now cheap and should be bought from the bankers. This would
not only make the financial system more resilient, it would also
do so in the economic interests of the customers of these
different institutions and without the requirement for onerous
amounts of unproductive capital.

At the heart of this approach is the notion that it is
economically sensible for different institutions to value the same
assets differently if they have different liabilities. But this
notion often runs counter to the practices that are put in place
to support transparency and common standards—such as the spread of
mark-to-market accounting or the use of third-party credit ratings
and bureaus. And it could reduce trader liquidity between crises.

If all financial institutions are required to value the
assets in the same way, through their audit rules, their capital
adequacy calculations, or their solvency rules, then when one firm
sells an asset, it induces other firms to sell more, causing a
vicious spiral driven by herd-like panic, aggravating a collapse
in market prices. In these circumstances almost no amount of
capital would be enough to prevent a bank from suffering a run.

Homogeneous behavior, not risky assets, is the main avenue
of systemic risk. Homogeneity, not size, determines whether a
financial system is shallow, fragile, and prone to falling over. A
commonality of standards and rules can support trading activity in
quiet times, giving the illusion of liquidity. But trading
liquidity is a false god that vanishes at the first sign of
trouble.

We must not confuse modes of operation with goals. The
holy trinity of transparency, common standards, and the removal of
trading restrictions is a good mode of operation but not the
ultimate goal, which is to create a financial system that is
resilient and serves the multiple needs of the consumers of
finance.

Mark-to-Funding Accounting

I have earlier proposed a "mark-to-funding" accounting
system to address this issue. It does so by allowing institutions
to value their assets based on the time they have available in
which to sell them. A bank with short-term money-market funding
has to value assets based on their price if they were to be sold
tomorrow, as with mark-to-market accounting. In fact, we currently
allow banks to define many assets as "hold-to-maturity," even if
they lack the maturity of funding to keep them that long with any
certainty.

Life insurance funds with long-term liabilities rarely
need to sell significant assets tomorrow and could therefore be
allowed to value them based on long-term valuation, such as a
model that discounts to the present value of all the future income
the asset produces. Instead, the proposed Solvency II regime for
long-term savings emphasizes a mark-to-market approach that will
make the financial system more fragile. In some ways, Solvency II
is even worse for financial stability than the original Basel II
accord on bank supervision, which had to be quickly revised after
the crisis erupted.

Segmenting the financial system according to the maturity
of liabilities would bring other benefits. Contrary to popular
belief, financial crises are not caused by people knowingly taking
bad risks. The human desire for retribution would like this to be
the case, and there is never any shortage of poor, deceitful
behavior prior to crashes. But that is there all the time. We need
to root it out and ban many people from financial activities, but
doing so will not prevent financial crashes.

Financial crashes always follow financial booms. Financial
booms take place because, collectively, people do things that they
believe to be virtually risk-free—so safe, indeed, that it makes
perfect sense for them to double up. It is the doubling and
tripling up by almost everyone, not malfeasance from a few crooks
that drives the booms that lead to the busts. In booms,
traditional bank lending and leverage surge. Indeed, it is the
widespread and unbridled optimism of the times that will make it
hard to secure criminal convictions against individuals. Much of
the blame is a collective one.

Mark-to-market valuations and price-sensitive risk systems
accentuate this process. As asset prices steadily rise, the value
of collateral goes up and volatility goes down, suggesting that it
is safe to lend or borrow more when, with the wonderful vision of
hindsight, we can see that lending and borrowing should be scaled
down in the face of increasingly unsafe valuations. The opposite
process occurs in a bust. The collapse in valuations makes it
safer to lend but banks don't, as the current value of collateral
and volatility suggest to the banks' risk systems that there is no
room to lend safely. Banks forget that the credit mistakes are
made in the boom, not the bust.

We need a financial system that is less circular and less
self-referential if we are to wean ourselves off boom-and-bust.
Another way of putting this is that we need a method of
risk-managing the financial system that is less statistical and
more structural: less dependent on us doing what we repeatedly
fail to do—to correctly measure fluctuations in risk and value
through time.

Structural risk management is about recognizing that there
is no one thing called risk and that it is not possible to
aggregate all risks into a single number, but rather that there
are a handful of different risks—mainly market risk, credit risk,
and liquidity risk. These are fundamentally different risks. We
know this not because we give them different names, but because
they have to be hedged differently.

Credit risk, the risk of a default, is hedged by
diversification across a number of different credit risks.
Liquidity risk, the risk that you cannot sell an asset
immediately, is not hedged by diversification across a number of
different but illiquid assets; it is hedged through having time
before assets need to be sold. Market risk, the risk of price
changes, is hedged through a combination of diversification across
assets and across time.

Nurturing Diversity

By virtue of having different liabilities—including the
need to repay a depositor, or to provide a pension or a life
insurance payout—different institutions and people have different
capacities for these different risks. A bank with short-term
depositors has a capacity for taking credit risk but not liquidity
risk. A young pension or life insurance fund has a deep capacity
for taking liquidity and market risk, but not credit risk.

Institutions should be required to put up capital against
any mismatch between their risk capacity and their risk-taking,
thereby encouraging them to stick to taking risks that they have a
natural capacity to absorb (making them naturally hedged if their
estimates of value and risk prove wrong). This is fundamentally
different from the ring-fencing that has been proposed in some
quarters. It will encourage risk transfers between the different
parts of the financial system—the right kind of risk transfer, not
the kind that went on before. Under our proposal, banks and life
insurance funds might continue to serve their customers as they
do, but banks would later strip out and sell their liquidity risks
to pension funds and buy credit risks from them.

We are a long way from this approach, but the attempt to
make banks more liquid through the application of short- and
long-term liquidity ratios in the revised accord on the
supervision of international banks (revised Basel II) is an
important start, albeit one that is being strongly resisted by the
banks.

Systemic resilience is not about the size of a market or
the degree of trading activity and liquidity, but about its
heterogeneity. The natural diversity of any economy—small or
large, rich or poor—must be nurtured, not artificially snuffed out
by sacrificing long-term investment and systemic resilience on the
altar of short-term trading liquidity and undue reverence to
today's price. Risk capacity, not some statistical risk
sensitivity, should be the watchword of regulation.

Conclusion

"Market-to-market" accounting—in which financial
institutions value their assets based on the price they could be
sold for the next day—encourages herd-like selling in downturns
and herd-like buying in upturns, exaggerating financial market
manias and panics. It is thoroughly procyclical. It suits banks,
given their dependence on short-term money-market funding but is
less appropriate for life insurance and pension funds, given the
longer-term nature of their liabilities and different risk
capacity. Were insurers permitted to value their assets based on
the time they have in which to sell them, it would bring much
greater equilibrium to financial markets. Under "mark-to-funding"
accounting, asset valuations would be based upon an assessment of
the cash flows generated over the period for which funding is
guaranteed. An approach to accounting and asset valuations that
better reflected the real diversity of liabilities and risk
capacity in the financial system would break up of the financial
herd—reducing the risk and severity of financial crashes.

Avinash Persaud’s career spreads across finance,
academia and public policy. He is currently non-resident
Senior Fellow at the Peterson Institute for International
Economics in Washington, Emeritus Professor of Gresham
College and non-executive Chairman of Elara Capital PLC.
He holds a number of non-executive board positions. He was
chairman, regulatory sub-committee of the UN Commission on
Financial Reform; Chairman, Warwick Commission; Member of
the UK Treasury’s Audit and Risk Committee and the Pew
Task Force to the US Senate Banking Committee; Visiting
Scholar at the IMF and ECB and Distinguished Advisor,
Financial Sector Law Reform Commission of India. He is a
former senior executive of J. P. Morgan, UBS, State Street
and GAM London Ltd. He is a former Governor, London School
of Economics and 2010 President of the British Association
for the Advancement of Science (Section F). He was elected
Director of the Global Association of Risk Professionals
and the Royal Economics Society. He won the Jacques de
Larosiere Award in Global Finance from the Institute of
International Finance and was voted one of the top three
public intellectuals in the world on the financial crisis
by a panel for Prospect Magazine

Friday, October 10, 2014

In her newest global policy agenda the managing director of the IMF says that the world should grow more as growth is needed to create more jobs. That sounds nice.

She also says that 'decisive structural reforms' are needed 'to bolster confidence'. That also sounds nice, or to be more precise: that sounds nice to those who embrace and advocate the structural reform agenda of the IMF.

But is it nice or good or wise to increase economic growth and implement the structural reforms the IMF advocates?

I doubt.

It depends on what kind of growth and what kind of 'structural reforms' one favours. The kind of structural reforms the IMF advocates and demands (!) are meant to bolster confidence of business leaders, policymakers and others who belong to powerful elites.

Creating more jobs for 'normal', less powerful, or even completely powerless people, and jobs for the underpaid who deserve better payment and better better working conditions, would contribute to a world with more equal wealth and power that I and many others (including some staff members within the IMF) favour.

A 'growth' (or de-growth) and 'reform' agenda is needed that is responsive to the need for a more social and less unequal world, as well as to the need for measures and policies against climate change.

I am afraid we need a different "global policy agenda" than the one suggested by Christine Lagarde.

About Me

As a kid I liked numbers and the sound of strings. I considered studying engineering but chose social sciences because of my interest in people. I combine a theoretical interest with a practical, social approach which brought me to the sphere of policy research. I am interested in reducing the disparity between poor and rich, between the powerful and the less powerful.
In 1973 and 1982 I lived in Latin America. In the mid-1980s, I was able to create an international forum to discuss the functioning of the international monetary system and the debt crisis, the Forum on Debt and Development (FONDAD). I established it with the view that the debt crisis of the 1980s was a symptom of a malfunctioning, flawed global monetary and financial system.
I was one of the driving forces behind the creation of the European Network on Debt and Development that was established at the end of the 1980s to help put pressure on European policymakers.
In 1990, before the beginning of the Gulf War, I cofounded the Golfgroep, a discussion group about international politics comprising journalists, scientists, politicians and activists that meets regularly.
The website of FONDAD is www.fondad.org